Options Trading for Beginners
An option is defined as “the right – but not the obligation – to buy or sell an asset at a fixed price before a predetermined date”. We’ll break this definition down into its components:
The Right, Not the Obligation
Buying Gives You the Right. When you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to do so at a fixed price.
Selling Imposes the Obligation. Selling options obliges you to buy from (if we sold puts) or deliver to (if we sold calls) to the option buyer if he decided to exercise the option.
To Buy or Sell an Asset
This component defines the type of option – calls and puts.
Call Is to Buy. The reason it is named a call is because when you buy a call, you can “call” the asset (e.g. stock) away from the person who sold the call option to you.
Put Is to Sell. It is named put because when you buy a put, you can “put” the asset (e.g. stock) to the person who sold the put option to you.
At a Fixed Price
Every option has what it’s called the “Exercise Price” or “Strike Price”. The Strike Price is the fixed price at which the option can be exercised.
So if you buy a call option that has a strike price of $100, then you have bought yourself the option to buy the asset for $100.
In the real world, you would only consider to exercise your right to buy that asset at $100 if the asset is actually worth more than $100 in the market. Otherwise there would be no point. It would mean buying the asset for $100 when it’s only worth, say, $90 in the market.
Before a Predetermined Date
Continuing from the previous example, your right to buy an asset at $100 can only be exercised up until a predetermined date – known as expiration date. Expiration date is the date before which the option can be exercised. After this date, your right to buy an asset has expired and your option is worth zero.
To summarize, the options trading for dummies’ components of option includes:
|The Right, Not the Obligation||Buying Gives you Right
Selling Imposes the Obligation
|To Buy or Sell an Asset||Call is to Buy
Put is to Sell
|At a Fixed Price||Exercise Price or Strike Price|
|Before a Predetermined Date||Expiration Date|
This definition is adopted from Guy Cohen’s book, Options Made Easy. I believe it is the best book for introducing options trading for dummies. I use the book early in my options trading journey, and I still use it now. If you want to know more about Guy Cohen’s work, check out the recommended reading and resources page.
Don’t like reading? Then you should consider options 101 course from options university. It’s a video course that explains common misconception in implied volatility, time decay, etc. Very valuable especially if you’re just starting out trading options.
This article covers pretty basic material on options. From here, I recommend that you open an options trading practice account – which basically the same with opening demo account for stock trading – to get a feel of real option trading before putting your real money at risk.